Goldman Sachs: The US Dollar Is Far Weaker Than Current FX Pairs Make It Seem
A team at Goldman, decidedly different team from the one which this morning said the EUR could drop to a 1.16 level shortly, looks at recent fund flow data and notes that with the US now perceived as a safe haven to the rest of the world, particularly Europe, a fact which implicitly is a huge benefit to the treasury supply onslaught as buyers for USTs no matter the yield or maturity, are easily found in this environment of insecurity. No surprise there: it is almost as if Europe's problems were engineered, courtesy of a EURUSD which was kept too high, for too long, by too many market participants. Goldman's conclusion is that the dollar is not the fundamental safe haven it is portrayed to be, but is, once again, merely the best of the worst. As Goldman's Robin Brooks highlights: "non-Treasury portfolio inflows are still falling short of covering the monthly trade deficit, in contrast to before the crisis when they were more than enough. This is consistent with our often repeated view that the BBoP (broad basic balance) for the US remains weak and is why – even in the face of strong foreign inflows into Treasuries – we remain cautious about the USD outlook."
Foreign participation – both official and private – was 20.1% for the data available for May, close to the historical average of around 17% and down from a peak of 40% in the immediate wake of the global financial crisis. Though this is only an incomplete picture – it ignores the secondary market – it does argue against reserve managers piling into USD. We get the same impression from other data sources we look at, notably Asian reserve accumulation, which also does not point to a sharp shift in favor of USD. We will continue to monitor foreign participation in Treasury auctions, and the broader portfolio flow picture, with a view to revising our USD outlook as warranted.
The primary reason for the increasingly strong bid for gold is explained by Brooks' observation: while unwinds in existing FX carry pairs continue to implicitly benefit the dollar, when it comes to allocating capital to a safe haven, the only recourse continue to be gold. And as FX is fickle, all it takes is one massive short covering spree to invert the balance of power once again in the direction of the EUR: all that would be needed is a wholesale realization that the consolidated US balance sheet is in far worse shape than that of Europe, and for the herd to shift from one side of the boat to the other. Yet should more volatility come into FX markets, gold would benefit even more.
From Goldman Sachs:
- Last week ended with the USD appreciating sharply, on escalating sovereign fears and weaker-than-expected US payrolls.
- This strength runs counter to our forecast, which is driven by an underlying picture of still weak portfolio inflows, something we have emphasized repeatedly in our BBoP framework.
- But the Euro crisis has the potential to boost foreign inflows, if foreigners – reserve managers among them – decide the US is the “best looking horse in the glue factory.”
- In light of this, we review US Treasury data on foreign portfolio flows to the US, which in March registered an all time high. We also survey more timely Treasury auction data for foreign take-up.
- We conclude that the fundamental picture – fear aside – is still not USD supportive and will continue to watch closely for any changes
1. The week ahead
Last week’s batch of PMI’s – pointing to still strong industrial activity in May – initially allayed fears that the ongoing crisis in Europe is spilling over into the real economy. But comments from the new ruling party in Hungary that the country stands on the verge of a sovereign default – unwarranted in our view – and weaker-than-expected US payrolls delivered a one-two punch on Friday that caused the SPX to fall 3.4% and forced EUR/$ through 1.20 to its lowest level since 2006.
Over the weekend, a G-20 meeting of finance ministers and central bank governors stepped back from a global bank levy, acknowledging differences across countries in how – and whether – such a measure should be adopted. The focus today and tomorrow is on the Efofin meeting, at which details of the sovereign SPV structure may be unveiled.
Against this unsettled backdrop, the most important hard data this week are out of China and they will inevitably be parsed for signs of weakness, especially following last week’s – in our view largely seasonal – drop in China’s PMI. We expect IP to grow an above-consensus 17.5% yoy in May, only slightly below the 17.8% yoy April pace, while year-to-date growth of fixed asset investment through May should slow to 25.6% yoy, essentially in line with consensus. Exports should grow an above-consensus 38% yoy, up from 30.5% yoy in April, on a low base, while retail sales growth should inch up in May. CPI inflation should rise in line with consensus to 3% yoy from 2.8% in April. In the US, Friday brings retail sales for May, which we think will grow a stronger-than-consensus 0.5% mom, but excluding autos we anticipate a slight contraction.
The week has a clutch of central bank meetings. Following the release of Q1 GDP on Tuesday (we expect strong, consensus-like growth of 2.5% qoq), we expect Brazil’s central bank to hike 75 bps. Governor Meirelles’ comments at the G-20 summit this weekend betrayed little concern over ongoing sovereign fears elsewhere. We also expect the RBNZ to hike 25 bps on Wednesday, though a hike may be accompanied by a dovish statement, following the Bank of Canada’s recent template. We expect South Korea’s central bank to remain on hold, and the Bank of England and ECB to do likewise.
2. USD keeps appreciating …
The DXY index, a widely followed – if in our view outdated – measure of US$ strength, is now around the same level as in November ‘08 after the Lehman collapse. On a broader trade-weighted basis, the US$ has also risen, though – because EUR/$ has a smaller weight – not as much. We are naturally asking ourselves – as are many others – if this appreciation is simply a repeat of Q4 2008, when safe-haven buying drove USD sharply higher, or if it reflects more fundamental strength. To look at this, we look to data on foreign portfolio flows published by the US Treasury, popularly known as the TIC report (short for Treasury International Capital). The latest release available shows that net long term portfolio flows to the US amounted to $140.5 bn in March, a big turn from net outflows of -$72.8 bn in August 2007 and -$33.1 bn as late as January 2009. Indeed, the March release eclipsed the previous high of $135.8 bn in May 2007, just before the start of the global financial crisis. We next examine in detail whether the TIC data signal rising fortunes for USD, though we caution that the latest available data – for March – predate the serious escalation of the Euro zone crisis from mid-April.
3. But the rise is driven by fear …
Even if total portfolio inflows are once again looking strong, their composition points to weakness. Foreign flows into US Treasuries – at 77% of total net inflows – were dominant in March 2010, while in May 2007 – the previous high for net long-term inflows – they accounted for only 17%. In contrast, net inflows into US corporate debt made up only 11% of the total in March 2010, compared to 58% back in May 2007. Flows into US equities were 8% of the total, far below the 31% in May 2007. Agency debt is the only category where the picture is almost back to pre-crisis levels. Net agency inflows were 16% of the total this March, only a trifle below the 20% recorded in May 2007. Overall, this shift is symptomatic of the global “flight to safety” that has benefitted US Treasuries, which has come in many ways at the expense of flows into other, more growth-oriented assets.
4. ...Not underlying strength
As strong as foreign flows into Treasuries are, we discount their importance for USD somewhat as they may be substantially currency hedged, reflecting in part the steepness of the US yield curve. Indeed, their historical correlation with trade-weighted USD is negative, indicating that Treasury inflows are not a reliable driver of USD strength. Meanwhile, as we have detailed above, other flows to the US are still very weak, notably those with a growth orientation, like flows into corporate debt and equity. It is these flows that – unlike Treasury flows – have a positive correlation with trade-weighted USD and are thus a more reliable driver of USD strength. If we total up private (excluding central bank purchases) non-Treasury inflows to the US and add them to the monthly trade deficit, this in March 2010 gives us a negative balance of -$12.8 bn, far below the positive balance of $37.8 bn in May 2007. This highlights that private, non-Treasury portfolio inflows are still falling short of covering the monthly trade deficit, in contrast to before the crisis when they were more than enough. This is consistent with our often repeated view that the BBoP (broad basic balance) for the US remains weak and is why – even in the face of strong foreign inflows into Treasuries – we remain cautious about the USD outlook.
5. No indication that foreign reserve managers are piling into USD
With foreign flows into Treasuries at all time highs – even if we discount their importance for USD – are reserve managers piling into USD at the expense of other currencies, notably the Euro? For this, we look to foreign participation in US Treasury auctions of longer term securities, which the US Treasury also publishes. Foreign participation – both official and private – was 20.1% for the data available for May, close to the historical average of around 17% and down from a peak of 40% in the immediate wake of the global financial crisis. Though this is only an incomplete picture – it ignores the secondary market – it does argue against reserve managers piling into USD. We get the same impression from other data sources we look at, notably Asian reserve accumulation, which also does not point to a sharp shift in favor of USD. We will continue to monitor foreign participation in Treasury auctions, and the broader portfolio flow picture, with a view to revising our USD outlook as warranted.